Inflation Rate and Consumer Price Index

Causes of inflation

It isn't easy to single out one specific cause of inflation but there are some sound explanations that do a good job of describing this phenomenon. Before we get into the details you need to understand that there is no clear cause and effect explanation. Inflation does occur, we see it happen in real life but all we can really do is observe this and make our best estimates as to why it is happening. Fortunately, there have been a lot of smart people studying this for a long time so we have a pretty good idea on why inflation happens and what the likely causes are.

Money Supply

The money supply is thought to play a major and important role on the effect of inflation. As the supply of money in the economy increases (i.e. the amount of money in circulation), the pressure on the economy to "keep up" and increase output also rises. This leads to price increases, because if the amount of money is increasing then its value is decreasing. It follows then, that if the value of the money is decreasing then you'll need to spend more in order to get the same amount of goods and services which is the definition of a price increase and hence inflation.

Other Models

There are other models of inflation including:

  • Demand-pull inflation: Inflation is explained by demand increases in the economy because of increased spending by public (government fiscal policy) and private enterprise.
  • Built-in inflation: Inflation caused by the expectation of inflation occurring. For example, employees expect that inflation will happen, and so they negotiate for wage increases in order to mitigate the cost of inflation. Well, this in itself is causing inflation whether or not it would've occurred naturally in the economy.
  • Supply-shock inflation: Inflation that is explained by large drops in the supply of goods, especially for items that are sold across the economy is large quantities (energy and food). For example, say there is a major decrease in the supply of wheat. This will in turn increase not just the price of wheat but any other item that uses wheat as an input.

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